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End To Short Volatility Trade?

Spectacular drawdown levels in some popular volatility ETNs vindicate analysts who warned about the perils of the short volatility trade.

Many have warned about the bubble in short volatility trade using fundamental and technical analysis arguments. I have also done this in the context of trying to point out flaws in backtest results that some quants were using in support of these strategies.

When a trade gets crowded it implodes no matter how good backtests look. This is what happened to the short volatility trade but this time is interesting because it marked termination of XIV ETN after its NAV fell by more than 80%. Below is a drawdown chart of XIV.

No, this is not an error, the drawdown is 95% !!!

The financial industry but also regulators must get their act together. In recent times instruments have been designed with the only purpose of transferring wealth from the public to their designers. These include these volatility ETNs and weird things like cryptocurrencies and ICOs. The instruments are based on the same principles of offering hopes and dreams of quick riches to the public.

Of course, when something is public and offers wild dreams of easy money it gets crowded fast and then implodes. Those who conceived the scheme usually get away with it but they leave pain and destruction behind them.

As I wrote in a tweet yesterday, playing with volatility is like playing with fire. Volatility is fat-tailed and anyone who uses a strategy to exploit may face ruin as times passes. A sensible volatility strategy in my opinion is taking advantage of spikes via the use of positive convexity. This can be a long volatility calls but time decay costs money. There is no free lunch. Anyone who thinks there is free lunch at some point in time faces reality.

Charting and backtesting program: Amibroker

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2 Comments

  1. Drew Wells

    I think it is important to distinguish dangerously aggressive ways to short vol from conservative ways to short vol. Long SPY is synthetically short vol; short SPX cash-secured puts is explicitly short vol but has half the beta of long the notional equivalent SPY. Each, sized appropriately, can reasonably be regarded as conservative; and the addition of a properly sized put selling strategy to a diversified portfolio can be regarded as even more conservative than excluding it due to the diversification benefits of accessing the volatility risk premium. Shorting the front end of the VIX futures curve after that strategy has become ridiculously popular was idiotic. Shorting the middle of the curve, as ZIV does, while still more aggressive than selling SPX puts, proved, as expected, to be less problematic. ZIV took a big hit, but survived, leaving it up 74% over the last three years compared to 40% for SPY. Too many express opinions on bonds without distinguishing between categories of bonds; and too many do the same with short vol strategies.

    • I agree, thanks for the comments. I was mostly referring to those aggressive strategies that use XIV and VXX. Strategies with positive convexity can be used to short volatility with no significant risk except time decay in some cases.

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